Stride, Inc. (LRN) Q2 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Second Quarter 2012 K12 Inc. Earnings Conference Call. My name is Tehisha, and I will be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Harry Hawks, CFO. Please proceed.

Thank you, and good morning. Welcome to the K12 Second Quarter Fiscal Year 2012 Earnings Conference Call. Before we begin, the company would like to remind you that statements made during this conference call and that are not historical facts may be considered forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve risks and uncertainties that could cause actual events or results to differ materially from those expressed or implied. In addition, this conference call contains time-sensitive information that reflects management's best analysis only as of the date of this live call. K12 does not undertake any obligation to publicly update or revise any forward-looking statements. For further information concerning issues that could materially affect financial performance related to forward-looking statements, please refer to K12's Form 10-Q and 10-K filings with the SEC. These filings can be found on the Investor Relations section of our website, www.k12.com. In addition to disclosing results in accordance with generally accepted accounting principles in the U.S. or in other words, GAAP, we will discuss certain information that is considered non-GAAP financial information. A reconciliation of this non-GAAP financial information to the most closely comparable GAAP information was included in our earnings release and is also posted on our website. This call is open to the public and is being webcast simultaneously on our website. The call will be available for replay there for 60 days. With me on today's call is Ron Packard, Founder and Chief Executive Officer. Following our prepared remarks, we will answer any questions you may have. I will now turn the call over to Ron.

Good morning, and welcome to our earnings call for the second quarter of fiscal year 2012. Our revenue for the quarter was $166.5 million, and EBITDA was $21.9 million. The quarter had increased revenue from higher than anticipated in-year enrollments, offset by revenue adjustments related to potential funding reductions. These potential funding reductions had an adverse effect not only on revenue, but also on almost dollar for dollar effect on operating income EBITDA. To begin, I'm pleased to report that just days ago, the Washington State Board of Education conferred upon the Washington Virtual Academies its prestigious 2011 Washington Achievement Award in the category improvement. The notification letter explain that the highly selective award is to celebrate the state's top performing schools based on performance on a comprehensive measurement index. We are proud to be affiliated with these schools. Turning to other developments in the past quarter. Our core online public school business continues to experience a favorable business development environment. Most recently, on February 1, the governor of Wisconsin signed a bill that increased the state's open enrollment period from 3 weeks to 3 months and establish the process for year round enrollments in certain cases. Taken in combination with the prior elimination of the virtual charter school enrollment cap, we believe thousands of additional Wisconsin students could enroll in this upcoming fall. Additionally, educational liberty took a big step forward in Iowa with the approval of the new statewide virtual academy. This online public school will service students in the Clayton Ridge school district and statewide in grades K through 6 beginning next year and will -- the middle and high school students in subsequent years. Using Iowa certified teachers to satisfy the demand for personalized learning programs, the Iowa Virtual Academy will help children succeed in ways…

Thank you, Ron. Good morning to all of you participating in our call and webcast. I'll address a few key topics before we open the call for your questions. First, I'll quickly summarize our second quarter and 6 months year-to-date results as compared to the comparable period last year. Revenue in the quarter of $166.5 million is an increase of over 29%. On a year-to-date basis, approximately $360 million of revenue is a 36% increase over prior year. EBITDA of $21.8 million is a decrease of 10%. However, the year-to-date revenue, excuse me, EBITDA of $43 million is an increase over prior year of about 10%. Operating income for the quarter of $7.1 million, and a year-to-date operating income of $15.4 million are an increase over prior year on a year-to-date basis of about $4 million. Net income, $4.2 million in the quarter, $8.8 million year-to-date. On a year-to-date basis, that's about $1 million decrease versus prior year. EPS in the quarter, $0.11, year-to-date, $0.23. $0.23 compares to $0.30 prior year. Second, it's worth another comment, as Ron mentioned, we made a revenue adjustment in the quarter to allow for potential funding cuts, which may occur. And we've thought that was prudent to do. That is unusual for us. We've never had that kind of situation before or for the past number of years. The net total adjustments made throughout the year was actually net positive. And so this is an unusual item where we are reacting. We believe in a prudent way to a short list of just a low single-digit number of states where there may be changes in funding. Third I'd like to comment is how that affects the sequential look at the numbers. We've talked about the comparison to the comparable period last year. On a…

[Operator Instructions] Your first question comes from the line of Suzanne Stein from Morgan Stanley.

First of all, I wanted to just confirm that there are no one-time charges in the quarter.

Well, there are some. We just didn't break them out.

Can you give us a sense of what the one-time charges would be?

Well, the transaction-related expenses, systems development cost were consistent with what we said at the beginning, in the first quarter. And we said there, and we haven't updated it or changed it, that -- hang on a second, let me just get it and I will give it to you. I believe we said, $6 million to $7 million. Sorry, since we didn't bother to break it out this time, I want to go back to the first quarter and make sure I get it right to you. So why don't you continue, and I'll come back.

Okay, sure. The Q2 students in managed schools increased versus Q1. I know you touched on it. But can you give us just a little more insight into why that number changed so significantly?

Well, what we're seeing is -- we're seeing, again, stronger than anticipated student demand. So remember, we had seen for the year, in September and October, much more growth in enrollment than we had thought we would have. And that trend is continuing. So we're continuing to see an increase in the number of students and student demand. And we're also seeing the cost of -- the cost to get a lead is going down, and conversion rates are higher. So we're just -- the in-year enrollment is continuing to trend stronger than anticipated student demand.

So following the negative press that started in December, has there been any change whatsoever? Or are you just seeing just kind of business as usual on the demand holding up?

We've seen no perceptible change in student demand at all. In fact, you might think it's even stronger than anticipated. But we -- in general, we can see no observable effect on student demand of any of the events of the fall.

Susie, just to follow up. What was mentioned in our Q1 release was the following: Transaction merger, integration system, implementation-related cost of $6 million to $7 million for the year, losses from startup initiatives of $5 million to $6 million for the year. And we said that, that would be more front-end loaded in the year. And so, in terms of the transaction costs, and that's largely correct. In terms of initiatives, losses from startups, that's probably another $2 million in the back half of the year for that. But the reason we didn't break it out, just to be clear, in the second quarter release is that we're going to live with these kind of expenses, and we're not providing adjusted EBITDA or a schedule of one-time only type of expenses. We're just going to live with them and report numbers to you as they are reported. So we're trying to be even more and more conservative. And when we give you an EBITDA number, it's fully loaded.

Your next question comes from the line of Sara Gubins from Bank of America.

I wanted to follow-up on the comment about the $8 million adjustment to revenue because of funding. Can you just talk about what you're seeing in the states that you think will lead to that lower revenue? And when would you expect to know for sure?

Sure, I can take that. So there's a few states where there's been some kind of, I don't want to say statements, whatever, that there may be funding reductions, and that's different on you. We try to model out always what we expect for funding, and we leave some room to have some. So we just felt it was prudent and take into account that this could happen, which means you adjust your revenue downwards for the quarter and taken to account what happened for the first quarter as well. These are by no means certain. I would describe them as possible, but not certain. So if they don't happen, then it becomes very, very easy for us to make numbers. And if -- at the top of the guidance. And if it does, you push down from there. But it's a hard thing to do, right? Because we have to estimate continuously what funding will be in states and have to try to reflect in the financials anything that we hear is positive that becomes possible to happen. If that helps -- and when you do that, it's one-for-one effect, not only on revenue, but also in EBITDA and operating income.

And when do you think you would know about this? I mean, this isn't typically the budget season for states. So this would be a midyear budget cut?

It absolutely would be a midyear type of cut. And we -- like I said, previously, up until probably until 2008, you never really saw much adjustments or anything in the middle of a school year like there were set in the summer. And then as states had more fiscal tightness, you've seen in various times in the last several years, funding cuts, and sometimes you see funding increases as well. So generally, I'd like to believe that we've come to certainty on that -- on whether these will happen or not in the next few months. So I would think by April, we would know, with certainty, yes, they're happening, or no, they're not happening.

Okay. And then I know that you don't model it this way. But we have looked at revenue per average student. And even if I take out that $8 million, it was still down 7% year-over-year, which was well below what we saw in the first quarter. So I'm trying to understand what would be driving that, if its mix shift across states, or maybe funding cuts that you've already seen. If you can give any clarity on that.

Well, I think there's 2 things I can say to that, that would probably help. When you compare year-over-year with the previous year's quarter, that had an adjustments where this had, this $8 million down, I believe, and Harry can confirm this and have a $4-million adjustment off as it became positive variance a quarter ago. So that would give you another $4 million when you look at a quarter-over-quarter this second quarter versus last year second quarter. But there also, as you have the institutional manage programs growing at a slightly faster rate, there is some mixed shift to a slightly lower revenue from that mixed shift.

Okay. And then, last, if you could talk about the new state pipeline and whether or not you've seen any increased question following up on the New York Times article from either regulators or legislators?

With that, I think, we're still in the process that we're very happy obviously that we're going to be opening in Iowa. And we seem to be doing pretty well in that dimension. I think there are several other very good probability candidates. Do we see questions about it? Yes. I mean, is it affecting it? I think it's too early to tell. I mean, I think we'll have much better idea from that over the coming 3 to 6 months, as the picture becomes clear. But we see some questions, but it doesn't seem to be having a significant adverse affect to date, but that doesn't mean it won't.

Your next question comes from the line of Kelly Flynn from Credit Suisse.

I have a couple of questions. First of all, just back to the state funding issue that Sara was just asking about. Can you just clarify what exactly happened that was worse than your expectations? I mean, I think last quarter and in the past, you've had pretty good visibility on trends, at least maybe sort of 3 to 6 months out. So I mean, what exactly did you see that was so dramatically different than what you expected?

It was really in the last several weeks, last few weeks that we, in a few states, basically, had information that came to us that said there may be this much per-pupil funding reduction having -- one state having to do with some policies and the other state having to do with just budget-related cuts. And so we basically just got that information and just thought it was prudent to put it in there while we're obviously still in discussions to make sure that -- to try to make this not happen. But we just -- so we usually have pretty good visibility, but a lot of what you see is sometimes just positive adjustments and negative. And this just happens to be more material than usual in these type of adjustments. But that's what happened. And it was in -- I guess, there's issues in potentially 2 or 3 states that are driving this. We just thought it was prudent to make the adjustment.

Is this, I guess, a scene that we can extrapolate? Is it to do with just, I guess, late cycle pressures? Or I think you mentioned policy decisions? I mean, can you just...

I wouldn't extrapolate this trend. I mean, I've been doing this probably now 12 years, and we haven't seen this very often. If you remember back, I think it was back in the '08, '09 year, we saw some of this happening in the spring because of the massive recession. But I wouldn't anticipate it. Usually they're not initially material because K12's got so many -- we're so diversified in terms of our states and portfolio that it doesn't tend -- and it tends to be always be offsetting effects. So I wouldn't extrapolate this trend. But it is a constant thing that we do is adjust estimates if we get new information. And this just happened to be more material this last quarter.

Okay, great. And then second question just relates to the guidance. Historically, the second half is, I don't know, let's say 35% to 45% of the annual EBITDA. So I mean, given that, I'm a little surprised you didn't reduced the EBITDA guidance you've been -- well, you didn't reduce it, but I'm surprised you did not reduce it. So that said, I mean, can you talk about some of the mechanics? First of all, the revenue. What kind of sequential revenue growth should we expect in the third quarter, in the fourth quarter? And maybe specifically, address this $8 million adjustment. Is there kind of an extra adjustment in the quarter because you included the Q1 adjustment and therefore, revenue should grow sequentially? Or how should we think about that in the third quarter?

Yes, I'll take the high level and Harry can follow-up on, on this. So essentially, when you have these adjustments, you made the second quarter took a disproportionate hit than normal. And then we reforecast based on the new information. And in addition to -- we were able also to streamline our costs structure to additionally reduce expenses for the next 2 quarters to offset some of what these funding reductions are. So the combination that you allowed us to maintain basically, the mid-point of our EBITDA guidance of where it was on the first quarter call. So it's a combination of that -- those funding -- possible funding reductions are being offset by 2 things. One is student enrollment continues to be strong versus so we see increased revenue from higher enrollments. And then also, we've made expense adjustments to the next 2 quarters to reflect -- to offset the rest of the difference. And Harry, you want to add to that?

Yes, I will. The first thing I want to actually add a little bit of emphasis to the point Ron has already made, the process of trying to manage and calibrate the revenue recognitions, state by state by state is the dynamic process that goes on, frankly, every single month, is a normal routine management activity of the company to work with state audits, confirming enrollment numbers. So there's an ebb and flow every single month as we work to make the numbers right. And so this is unusual for us. But it's not at all unusual that every single month, we try to stay on top of this one state at a time. Moving onto the guidance. Let me be -- I'm going to make a real attempt to be responsive and helpful, but I just need to caution that anything I say here is not changing or amending the guidance that we just gave in the press release this morning because we give annual guidance only, and that's the guidance we give. And that's kind of frankly how we manage the business on an annual basis versus the quarter. However, in the spirit of trying to be responsive, if you take the -- we said that revenue is anywhere from $680 million to $690 million. If you use $690 million as an example, obviously, $360 million year-to-date revenue, that means $330 million in the back half of the year. That is -- does represent the normal sort of seasonal relationship that we have of less revenue in the back half of the year than the first half of the year. As you look at the implied -- the implication of an EBITDA range of $85 million to $95 million, or depreciation and amortization range which I guess the…

Oh, what I'm trying to figure out is this is $8 million hit, I mean, is it double counting because it's including kind of a charge or something that should have really been in Q1. And so you're kind of going to pick up some revenue in the third quarter relative to Q2?

Well, I guess I have to repeat what I just said.

Okay, no, it's all right. We can talk about it off-line. I don't want to take up too much of the call.

Your next question comes from the line of Jeff Silber from BMO Capital Markets.

Just one more question about the guidance. You had mentioned the potential for expense reduction in the second half of the year. Are there any specific line items where you may have an impact on that more than others?

We went through -- there really -- they're going to hit almost every line with -- there'll be significant amount coming out of -- SG&A would probably be the bigger one in some. There's a lot easier to do that than it is, obviously, the instructional expense. So I think you find it -- and I think you also see something come out of product development as well. So I would say, but there'll be expense reductions in all 3 lines. I mean, that's what management does as we react to news and we make the adjustment. So I think you'll see in all of them, but probably a little less though, instructional costs.

Okay, great. I appreciate that. I want to go back to the environment generally for your business and others in your area. I know in my state, and particularly in New Jersey, we've seen a lot of backlash from some folks in local school district opposing the progress of charter schools more because of fiscal issues saying that the money has being taken away from their local school district. I know you operate more in the state level. But are you seeing that kind of negativity across some of the state that you're operating in as well?

The reaction you described against charter schools, I'm pretty much been watching that since 1997, since I got involved in education. We see less of it because we're taking such a small percentage of kids from any district. You might see a district having 1% or 2% of the kids that it becomes a much lower effect, whereas if I open up a brick-and-mortar charter school, you could take 400, 500 kids from a single district. So I think it's less that type of reaction. Generally, I think the business development environment with regard to charter schools as a whole, maybe not at the local township level. But generally, I think there's becoming increased awareness that there's a lot of charter schools to do a great job in offering kids more choices. I mean, I think the movement is actually gaining steam more than losing steam. But that's just my observation of it. I think the other thing what we're seeing with our schools is because we're taking a lot of the kids that the system has already failed. And you look at what we're doing in Chicago with drop outs, I mean, I'm seeing tremendous demand for how we can use kind of hybrid settings or perhaps full-time virtual to allow kids who are either going to drop out or have dropped out of school to succeed. So I think it's hard to make a gross generalization, and it depends on the individual situation.

Your next question comes from the line of Mike Malouf from Craig-Hallum.

If I could just move the conversation to -- with international. Can you talk a little bit about what decisions need to be made before you complete that transaction? And then, assuming that, that does get complete, can you talk a little bit about the potentials there for revenue acceleration and any changes that you might actually implement with regards to doing that? Or is it just going to be just a standalone company without any impact?

Sure. So Web continues to grow very rapidly, I think faster than we expected it to grow. And so what's happening is we need to do obviously extensive just financial due diligence to make sure the company is what we believe it is and the information we get. And then we also need to prepare internally so that when we acquire a controlling interest that we can consolidate it. I believe the opportunities for Web are meant. Given the size of the, obviously, the Chinese market and the consumer pay nature, we believe that it could continue to grow at these rates for -- high rates for a long time. We've already opened a center, one center -- they've already opened a center dealing with younger children that can potentially also benefit from K12's content. So I think once we have it, you'll continue to do business as you're doing it, because it's doing incredibly well. But I think adding some online wraparound products and also adding more centers geared towards younger children as opposed to young adults, just completely -- just expand the potential of that business immensely.

Great. And then, how is Kaplan faring? And are you still on track for profitability next year?

So Kaplan, to the -- there's 2 things from that acquisition. One was the private schools, which we've actually transitioned most of those children to one of our existing 3 schools. So that part has gone very well. And then with regards to the insight network of schools, I think we will be because we, basically, we couldn't change the core operating model very much in the short time, given that we took those on in July. But I think with the change of the core operating model, we'll be able to move those to where they are contributing in the coming 2013 year.

Your next question comes from the line of Jeff Mueller from Baird.

Hate to beat the dead horse, but given the magnitude of the impact, I just want to circle back one more time on the $8 million and make sure that I got this right. So you're not taking a more conservative approach or anything to how you account for it. You've always had these adjustments, but the magnitude is bigger and maybe it's because the change was in one of your larger states this year. Is that the way to think about it?

I think that's generally right. We've always made these kind of adjustments. And it's not a science, right? Until you have 100% certainty that it will or won't happen, you're constantly estimating how likely is something to happen. And so you make judgments calls. And we try to err on the prudent side. Where -- if there's a possibility, we'll try to make those adjustments. And I think it is one of the states, one of the larger states. So just to be prudent, we're making the adjustment this quarter. It's just your point is right because it's larger states, it's more than one, the magnitude is amplified. But it's a normal process for what we do on a quarterly basis. It's just unusual that it happens in the midyear like it has happened and the state is a little larger.

Okay. And then the second one and maybe I'm front running the information you're planning to provide at the upcoming Analyst Day, but obviously, good to hear that the negative articles haven't had an impact on the business thus far. But, Ron, what are you guys looking at doing to maybe have better third-party data or something like that, that you can present on student performance to have some of the press accounts be more positive and kind of really use more of a data-oriented way in terms of the way that you look at the data instead of just looking at the average test scores?

That's right. I mean, and thank you for asking that. So we're planning -- we've been doing for a long time internally is we've looked, basically, we've been administering a third-party nationally norm test for several years now and we basically have looked at internally how were the gains of our students compared to gains for national norms, so you can measure what students are actually learning and how much they should be learning. So we've been doing that for a while. So I think what we're planning to do is work more with outside researchers than we have done previously and, basically, communicate pretty clearly that one is the virtual schools now are bringing in kids who were significantly behind grade level for the most part. And then, we're actually generating good gains with those kids. So I think one of the big -- one of the things we're doing a lot more of, we've always looked at internally ourselves, but we're I think beefing up the analytical capability of the company, and we're working with more third parties to actually publish some of these things. So that's a process that's underway, and we hope to have some of this and be able to share it with you on March 15.

Your next question comes from the line of Joe Jannsen from Barrington Research.

This is Joe Jannsen filling in for Alex Paris. Ron, maybe can you just dive a bit deeper on the -- with regards to enrollment and talk about the growth? And is that across-the-board? Or are some states driving the majority of that growth?

It's pretty much across the board that the states are performing ahead of forecast. Obviously, the cap states were capped. So you're not seeing any growth there, but you couldn't anyway. But we're seeing pretty much across the board we're seeing higher than forecast growth. It's an across -- the across the country thing. It doesn't seem to be depend on any region or state. It's everywhere. I think it's a combination of this model of education, which is a great choice for a lot of kids, is taking root. And an important point to emphasize is one, we take everybody who comes to us and they're -- everyone in our school has chosen to be there. And the reason they have chosen to be there is because what we're delivering, whether it be an incredible curriculum or great teachers, works for them. And that's just getting out. I mean, our customer satisfaction remains extremely high and a large percentage of our kids come to us because they're referred from some existing students, which is the best testimony in what we do.

Great. And just a follow-up on Susie's question about the New York Times article. You talked about the student demand side, no effect, the political side you won't know for another 3 to 6 months. Can you just talk about maybe the institutional and sales side of the business? Any drop off?

Yes, the institutional side of business, I think I mentioned in the call in the last 2 months, we signed over 200 new contracts with school districts. So that business seems to be continuing to go on effective to the best we can tell from any of the articles. And again, school districts are a lot -- are pretty sophisticated customers. And they look at the curriculum. They look at the product. And they can see it's great. And so I didn't -- we didn't expect it to affect that much, I mean, because the products are good. And we spent $260 million developing it. Now, school districts don't need to worry about whether 75% of the kids coming to the virtual schools are behind, because it doesn't affect what they're doing. What they're trying to do is buy the best product for what their needs are, and we believe we have that.

[Operator Instructions] Your next question comes from the line of Gary Bisbee from Barclays Capital.

Just want to follow up on the, I guess, 2 questions ago about what you're doing in light of trying to tell a better story after that New York Times article. One of -- in your press release sort of response to that, one of the things you mentioned was having provided data around the adequate yearly progress, about the longer the students are in your schools, the better they did or the better the progress was. And it's -- actually, you said you gave that data to the reporters. Is that data that you've published publicly for investors? Or is the data that's available out there? I guess, I was just sort of curious if you're providing data to reporter, but you hadn't given it publicly. If it was positive, it would certainly -- make a lot of sense in my view for all of us to see it.

Well, we had -- we have had in previous investor decks for several years a chart that showed that students who were the 7 years do better than 6, do better than 5 and better than 4. So that data had been in public investor decks for several years now.

And that's what you're referring to in that.

I believe so. I mean, I have to look at it specifically. But generally, we have provided for those decks how kids do based on longevity with the schools. And that's been, I think, at least for 2 years in the investor presentations. And also, if you look at our annual meeting deck, which I think is on our website, you'll see a kind of a summary of what we know and don't know academically in there as well. And it mentions that same fact in that particular PowerPoint slide.

Your next question comes from the line of Charles Nguyen from Neuberger.

How is the Board thinking about the cash on the balance sheet at this point? And have the priorities changed at all given the pullback in the stock?

No, I don't think we have less the stock price change what we do in any way to reform. I think the only difference is we'd be more reluctant to use it as a currency for acquisitions. But as -- and we're happy to have such an healthy balance sheet. And as I've mentioned previously, we're not looking at any large acquisitions. And we like having the cash. And I think we're, obviously, very serious about potentially buying the rest of the Web. And then, we're looking at some small acquisitions, but nothing significant. So I don't think it's changed any way, shape, or form other than our -- whether we actually use it as a currency.

Gentlemen, we have no more questions in queue. I would now like to turn the question -- the conference back over to Mr. Ron Packard for any closing remarks.

All right. Well, thank you very much, and we look forward to seeing, we hope, most of you at the investor in March 15. Please look for the details, and we'll be able to share a lot of things at that point in time. Thanks again.

Bye, everybody.

Thank you for your participation. You may now disconnect. Have a great day.